Can Kraft Foods (KFT), purveyor of such delicacies as Oreo cookies, Ritz crackers, Tang and Kraft Macaroni & Cheese, pass on the increased commodity costs related to the drought in the U.S.? If the company doesn't address the issue in today's earnings release or in the opening comments in its earnings conference call scheduled for today at 5 p.m. ET, then the analysts in attendance will surely prompt the company for drought related commentary.
Even though the cost for the actual product is small as compared to the packaging, transportation, marketing, etc., increased commodity costs have to be managed in some way. When companies face increased commodity costs they basically have the option to pass the costs on, absorb the costs, hedge the costs or some variation thereof.
In Kraft's 2012 Q1 earnings call held on May 4, 2012, the company reported broad based global growth, but the 1% growth of gum and candy was a disappointment and was attributed to the volatility in Southern Europe related to sovereign debt. The company noted it expects continued tempered growth until the issues in Europe are resolved.
For Q1, Kraft reported year-over-year revenue growth of 3% for North America and 11.5% in developing markets. Latin America, the Middle East and Africa clocked in double digit growth while Asia Pacific and Central and Eastern Europe grew revenue in the high single digits.
Kraft indicated it is on track for splitting the company into two public entities consisting of a grocery business and a snacks business.
Kraft noted it has been taking advantage of its Cadbury acquisition by distributing legacy Kraft products via the Cadbury distribution system. As an example, the company is distributing Oreo and Tang products via the Cadbury infrastructure system in India.
The Kraft-Starbucks arbitration hearing is underway following Starbucks (SBUX) termination of a licensing agreement where Kraft bagged and distributed Starbucks branded coffee in supermarkets and retailers. Starbucks claims Kraft mismanaged distribution and promotion of the coffee products and as a result terminated the licensing agreement. Kraft estimates the negative impact of Starbucks early termination of the licensing agreement could be as high as $2.9 billion, plus attorney fees. Apparently Kraft rejected an offer of $750 million from Starbucks in order to avoid litigation.
Kraft noted in its Q1 earnings call that it expects net organic revenue growth of 5% in 2012.
Kraft's stock price has been on quite a trajectory over the last year as shown below:
With Kraft's meteoric rise in stock price, unknown effects of rising commodity costs and the issues in Europe, an investor in the company might consider a protective investment strategy. As an example, a protected covered call or collar can be used to position a stock investment for a potential return, even if the price of the stock remains stagnant, yet protect the position from a large drop in price. A protected covered call may be entered by selling a call option against a stock and using some of the proceeds to purchase a put option for protection or "insurance".
Using PowerOptions tools, a variety of protected covered call positions are available for Kraft for expiration in January of 2013 as shown below:
The potential returns listed in the table above do not include consideration for receipt of dividend payments during the holding time. The potential return for the top position in the table when taking dividends into account is 3.4% (7.3% annualized) with a maximum potential loss of 7%. So even if the price of the stock drops to zero, the maximum potential loss for the protected covered call is 7%. The specific call option to sell is the 2013 Jan 39 at $1.59 and the put option to purchase is the 2013 Jan 35 at $0.88.
Protected Covered Call Trade
- Stock KFT (existing or purchased)
- Sell KFT 2013 Jan 39 Call at $1.39
- Buy KFT 2013 Jan 35 Put at $0.88
A profit/loss graph for one contract of the Kraft protected covered call is shown below:
For a stock price below the $35 strike price of the put option, the value of the protected covered call remains unchanged. If the price of the stock increases to around $43, the position can most likely be rolled in order to realize additional potential return.
Look forward to hearing your comments!